The Gold, Oil And US Dollar Relationship

Of the various vulnerabilities that traditional financial assets are exposed
to, a rising oil price is of particular concern. In 2004, oil hit an all-time
high of $56 per barrel, up 366 percent from the $12 low of 1998, and up 75
percent since January 2004.

Generally speaking, an increasing oil price results in increasing inflation,
negatively impacting the global economy, particularly oil-dependent economies
such as the US. Apart from increased transportation, heating and utility costs,
higher oil prices are eventually reflected in virtually every finished product,
as well as food and commodities in general. Unlike previous, spikes in
the price of oil, there is evidence that global oil production is peaking and
the flow will soon be in permanent decline.

The US has enjoyed inexpensive oil-based energy for nearly a century, and
this is one of the prime factors behind the unprecedented prosperity of its
economy in the 20th century. While the US accounts for only 5 percent of the
world's population, it consumes 25 percent of the world's fossil fuel-based
energy. It imports about 75 percent of its oil, but owns only 2 percent of
world reserves. Because of this dependency on both oil and foreign suppliers,
any increases in price or supply disruptions will negatively impact the US
economy to a greater degree than any other nation.

The majority of oil reserves are located in politically unstable regions,
with tensions in the Middle East, Venezuela and Nigeria likely to intensify
rather than to abate. Because of frequent terrorist attacks, Iraqi oil production
is subject to disruption, while the risk of political problems in Saudi Arabia
grows. The timing for these risks is uncertain and hard to quantify, but the
implications of Peak Oil are predictable and quantifiable, and the effects
will be more far-reaching than simply a rising oil price.

In the early 1950s, M. King Hubbert, one of the leading geophysicists of the
time, developed a predictive model showing that all oil reserves follow a pattern
called Hubbert's Curve, which runs from discovery through to depletion. In
any given oil field, as more wells are drilled and as newer and better technology
is installed, production initially increases. Eventually, however, regardless
of new wells and new technology, a peak output is reached. After this peak
is reached, oil production not only begins to decline, but also becomes less
cost effective. In fact, at some point in this decline, the energy it takes
to extract, transport and refine a barrel of oil exceeds the energy contained
in that barrel of oil. When that point is reached, extraction of oil is no
longer feasible and the reserve is abandoned. In the early years of the 20th
century, in the largest oil fields, it was possible to recover 50 barrels of
oil for each barrel used in the extraction, transportation and refining process.
Today that 50-to-1 ratio has declined to 5-to-1 or less. And it continues to
decline.

Hubbert's 1956 prediction that crude oil production in the US would peak in
the early 1970s and then decline, was greeted with great skepticism. After
all, production in the US was increasing and technology was improving. However,
there were no new major reserves being discovered, and his prediction proved
to be correct. Oil production in the US did peak in 1970, and has been declining
ever since.

Using analytic techniques based on Hubbert's work, oil and gas experts now
project that world oil production will peak sometime in the latter half of
this decade. We are now depleting global reserves at an annual rate of 6 percent,
while demand is growing at an annual rate of 2 percent (and that growth rate
is expected to triple over the next 20 years). This means we must increase
world reserves by 8 percent per annum simply to maintain the status quo, and
we are nowhere near achieving that goal. In fact, we are so far from it that,
according to Dr. Colin Campbell, one of the world's leading geologists, the
world consumes four barrels of oil for every one it discovers.

Once a supply shortfall materializes, the US will be in competition with China,
India, Japan and other importing countries for available oil. Many experts
are now predicting US$100 per barrel within the next two years. Some believe
it will go even higher. Taking geopolitical factors and supply/demand fundamentals
into consideration, it is impossible to predict how high the price of oil will
soar. One thing seems certain the age of cheap oil is over.

There are numerous social, economic and political implications related to
world oil production peaking in the next few years, but our concern here is
to examine how a rising oil price is linked to precious metals. The answer
to that question begins with the historical desire of Middle Eastern producers
to receive gold in exchange for their oil. This dates back to 1933 when King
Ibn Saud demanded payment in gold for the original oil concession in Saudi
Arabia. In addition, Islamic law forbids the use of a promise of payment, such
as the US dollar, as a medium of exchange. There is growing dissention among
religious fundamentalists in Saudi Arabia regarding the exchange of oil for
US dollars.

Oil, gold and commodities have all been priced in US dollars since 1975 when
OPEC officially agreed to sell its oil exclusively for US dollars. From 1944
until 1971, US dollars were convertible into gold by central banks in order
to adjust for any trade imbalances between countries. Up to that point, the
price of gold was fixed at US$35 per ounce, and the price of oil was relatively
stable at about US$3.00 per barrel. Once the US ceased gold convertibility
in 1971, OPEC producers were forced to convert their excess US dollars by purchasing
gold in the marketplace. This resulted in price increases for both oil and
gold, until eventually oil reached US$40 per barrel and gold reached US$850
per ounce.

Today, apart from geopolitical threats in oil-producing regions, supply/demand
imbalances from Peak Oil and increasing demand from developing countries, the
price of both gold and oil can be expected to increase as the US dollar declines.
With an ever-increasing US money supply, growing triple deficits and mounting
debt at all levels, the US dollar is likely to continue the decline that began
in 2001. Since then, foreign holders of US dollar assets have already lost
33 percent of their investment. How long will oil exporters continue to accept
declining US dollars? How long will they continue to hold US dollars as their
reserve currency?

At some point, they may decide to abandon the US dollar in favour of euros.
Russian premier Vladimir Putin and Venezuela's president Hugo Chavez have both
publicly announced that they may begin to price oil in euros in the near future.
Even Saudi Arabia has stated that it is considering pricing its oil in euros,
as well as in US dollars. There have even been discussions among Arab nations
about pricing oil in Islamic gold and silver dinars. If this happens, other
producers may follow suit and opt out of accepting US dollars for oil. Demand
for the currency will plummet, sending the dollar into a freefall while demand
for euros, gold and silver soars.

In addition, Middle Eastern oil producers would be forced to diversify their
vast US dollar holdings into precious metals and other currencies to protect
themselves from further losses. As losses mount, other large, non-oil producing,
US dollar holders such as Japan, China, Korea, India and Taiwan may also seek
to diversify out of US dollars. Eventually, this could result in a dollar sell-off
and a corresponding increase in oil and gold prices.

Over the last 50 years or so, gold and oil have generally moved together in
terms of price, with a positive price correlation of over 80 percent. During
this time, the price of oil in gold ounces has averaged about 15 barrels per
ounce. However, with recent soaring oil prices, the relationship has strayed
far from this average. While oil prices recently set an all-time high of $56
per barrel, gold prices have not kept pace and the gold:ratio fell to an all-time
low of 7.5:1. At US$56 per barrel oil, the gold price should be in excess of
US$840 per ounce. Some experts are suggesting that, in two or three years,
US$100 per barrel oil is very possible. At that price gold should be US$1,500
per ounce.

The gold:silver ratio has varied from 16:1 to 100:1. Currently it is about
66:1. Gold Fields Mineral Services expects this ratio to fall to between 40:1
and 50:1 in the near future. At a 50:1 ratio and a $1,500 gold price the price
of silver should be $30/ounce. At 16:1 it would be $94/ounce.

The size disparity between oil and gold markets must also be considered. While
annual gold production is approximately US$35 billion, annual oil production
is US$1.5 trillion, by far the largest-trading world commodity. As oil prices
increase and demand for US dollar diversification increases, there will be
an ever-expanding number of petrodollars and other offshore dollar holders
chasing a relatively small amount of bullion ounces.

In conclusion, the price of oil is poised to rise steadily as the supply/demand
imbalance increases and the dollar declines, even if there are no supply disruptions,
terrorist threats or geopolitical concerns to consider. As this happens, the
price of precious metals will climb until they eventually catch up to their
historic ratios. Should oil producers demand euros, dinars or precious metals
in payment for their product, the decline in the US dollar will accelerate
while the price of precious metals explodes. If oil producers and other foreign
US dollar holders begin to sell the trillions they hold and diversify into
alternatives, then the price of both oil and precious metals will rise to levels
that today are hard to imagine.

Nick Barisheff is the founder, president and CEO of Bullion Management Group
Inc., a company dedicated to providing investors with a secure, cost-effective,
transparent way to purchase and hold physical bullion. BMG is an Associate
Member of the London Bullion Market Association (LBMA).

Widely recognized as international bullion expert, Nick has written numerous
articles on bullion and current market trends that have been published on various
news and business websites. Nick has appeared on BNN, CBC, CNBC and Sun Media,
and has been interviewed for countless articles by leading business publications
across North America, Europe and Asia. His first book, $10,000 Gold: Why Gold's
Inevitable Rise Is the Investor's Safe Haven, was published in the spring of
2013. Every investor who seeks the safety of sound money will benefit from
Nick's insights into the portfolio-preserving power of gold. www.bmgbullion.com

The opinions, estimates and projections stated are those of the author as
of the date hereof and are subject to change without notice. The author has
made every effort to ensure that the contents have been compiled or derived
from sources believed to be reliable and contain information and opinions,
which are accurate and complete. Neither Nick Barisheff, nor Bullion Management
Group Inc. or any of its affiliates take responsibility for errors or omissions
which may be contained therein. Neither the information nor any opinion expressed
herein constitutes a solicitation for the sale or purchase of securities, and
investors are encouraged to seek advice from a qualified investment advisor
before making any investment decisions.